It’s possible to take advantage of both 1031 and the 121 Principal Residence Exclusion for the same property, so long as you understand the rules.
A 1031 exchange can be a useful way to defer taxes on gains from the sale of property used in a trade or business or held for investment. As a Qualified Intermediary, JTC works with exchangers as they relinquish an investment property and acquire another “like-kind” property, satisfying the rules for §1031 and allowing them to take advantage of its tax benefits.
But not every situation is cut and dry. What if only part of your property is used for business? What if you lived there previously but now rent out the home? Or what if you live in one unit of a duplex and rent out the other – what tax benefits can you receive?
At the heart of these complex questions are two parts of the tax code, sections 1031 and 121. Let’s break down each so you can see which applies to your situation, or if you’re one of the special cases where both may apply.
How a typical 1031 exchange works
Section 1031 of the tax code applies to the sale of business-use or investment property. It allows for the deferral of capital gains taxes and depreciation recapture on the gain from a property sale if the seller uses the sale proceeds to purchase a “like-kind” property within the appropriate time frame and follows specific exchange rules.
As the nation’s most trusted 1031 exchange accommodator, JTC has helped investors and property owners perform all different types of exchanges across a variety of different property types and ownership structures as part of prudent small business, retirement, or estate planning strategies.
It’s important to understand that IRC Section 1031 is meant only for business or investment property, which could be a warehouse or storefront, a rental home, a multifamily apartment building or office complex, or even shares in a Delaware Statutory Trust. §1031 is not designed for the exchanger’s primary residence. When selling the home where you live, there is another part of the tax code to consider.
What is Section 121 and who can use it?
Unlike Section 1031, which applies to properties used for business, Section 121 of the tax code applies to a person’s primary residence. From the IRS:
If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return with your spouse.
Instead of deferring gains by exchanging for a like-kind property, the IRC 121 Principal Residence Exclusion allows you to exclude a portion of the gains. The key to qualifying for 121 rests in meeting two conditions: the ownership test and the use test. Again, from the IRS:
You’re eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you’re not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home.
While there are exceptions to the five-year period and other rules that have to be taken into account, the important point for our discussion is that you have to have owned the property for at least two of the past five years and have to have used it as your main home for at least two of the past five years.
The ability to exclude gains makes Section 121 beneficial for those who don’t wish to reinvest the gains from a property sale, such as individuals who are retiring and want to convert to liquid assets. It also means you can use Section 121 at the end of your 1031 journey to maximize your retirement savings.
Going from §1031 to §121 for retirement planning
Under the right circumstances, it’s possible to convert your §1031 replacement property into your primary residence. For example: let’s imagine you own a small rental home that generates income for your family. As the years go by, you perform several 1031 exchanges to take advantage of the real estate market and secure the best possible property to continue to build wealth.
When your kids are grown and move out on their own, you no longer need a big house all to yourself, so you sell your residence (taking advantage of §121) and move into what had been your rental property, converting it into your main home.
Five years later, you’re getting on in years and want to retire. Since this home is now your primary residence, the sale could potentially qualify for §121. Thus, a 1031 property has been converted into a §121 property.
Of course, calculating the tax liability for the sale of a property like this is not simple. When converting 1031 exchange property to a primary residence, in order to be entitled to any portion of the exclusion, the taxpayer must own the property for a minimum of five years after acquisition. Additionally, the property must have been used as a primary residence for at least two of the last five years.
And in 2009, the rules for this scenario were changed so that the 121 exclusion is prorated, meaning the taxpayer can only apply the exclusion against the ratio of gain attributed to the time the property was held as a residence. For the ratio of gain that corresponds to the time the property was held for investment, taxes would be assessed. Any use of the property prior to 2009 would be treated as if it were the taxpayer’s primary residence. These types of complicated calculations are why it’s critical to get the right legal and accounting help to ensure the most recent version of the law is being followed.
The case above describes a property formerly used for business and subsequently used as a main home. But what if things are the other way around – if you used to live there, but now rent out the home?
Going from §121 to §1031
Let’s say you’ve lived in a home for some time, and over the years, it has greatly increased in value. When you choose to sell your home, your capital gain will exceed the $250,000 ($500,000 for joint filers) limit imposed by §121. That means you’d have to pay capital gains taxes on any amount in excess of $250,000 at the time of sale – unless you can also qualify for §1031.
The way to do this is by converting your main home into a rental property. Instead of selling your home, you move to another residence and rent out your home. After using your home as a rental property for a significant enough period to establish its use as an investment property, it could then qualify for both §1031 and §121 if it satisfies the conditions for both, meaning you can use §121 for part of your gains and §1031 for the other.
You could then sell the home and take advantage of the §121 exclusion for the applicable amount. The portion of your gain that cannot be excluded under Section 121 could be used to purchase a 1031 replacement property, deferring capital gains taxes and continuing to build wealth. While this scenario might not be feasible for everyone, it’s worth exploring if you have a high-value home and want to reinvest as much of your gains as possible.
In both of the above scenarios, a property was used for either business or personal use and then converted to another use to fall under a different tax category. But there are some situations where a property could be used for both business and personal use at the same time, and in these situations, both 1031 and 121 could be possible under the right circumstances.
How §1031 and §121 can be used simultaneously
Some properties are used partially as main homes and partially as business properties. A great example is a duplex. Imagine you, the owner of the duplex, live in one of the units while renting out the other. Technically, this is your main home (for §121) and also a rental property (for §1031). So which one applies? Neither? Both?
The answer is that part of your property will qualify for §121 and part will qualify for 1031. You can take advantage of the §121 exclusion, but only on the portion of the property in which you live. The sale proceeds from the other half of the duplex could potentially be used for a 1031 exchange.
This is an easy example, since a duplex is likely 50/50 between business and personal use, but there are other situations where the division would be more complex, necessitating careful calculation. Examples might be a property with both a residence and a separate home office or storefront, a property containing multiple homes with one being occupied by the owner, or a farm where a portion of the property is the owner’s residence.
Only the portion used for business or investment would be eligible for an exchange, with the portion used as a primary residence potentially qualifying for §121. There are a lot of possibilities, so property owners and their tax advisers have to calculate the specific percentages in order to determine the actual amount that can be exchanged. It’s crucial to get the right tax and legal help to navigate these complex rules.
What you need for 1031 success
It’s important to work with the right partners when pursuing a §1031 exchange, especially if you’re dealing with complexities like an added §121 exclusion. In addition to tax advisors and legal help, you’ll need a Qualified Intermediary to hold funds during the 1031 exchange.
JTC has decades of experience as a QI, with tens of thousands of successful transactions. Our team includes experts on all manner of exchange scenarios, including rare instances like simultaneous 121 exclusions. We offer tools that can help you follow IRS rules so you can have a successful exchange, no matter your situation.